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Venezuela: Oil and Chaos

“Investors are watching as Maduro finishes killing off what had been Latin America’s golden goose”

Venezuela is descending into chaos. Protesters have been killed, American diplomats expelled, a key op- position leader arrested. (The current crisis was sparked by protests against Venezuela’s extremely high levels of violent street crime, and spiraled out of control from there.)

As we’ve observed before, what is happening in Venezuela is neither new nor surprising -- it’s predictable based on our long observation of corrupt, resource-centered economies run by populist demagogues.

Why Bother To Look At Venezuela?

If this is the case, why do we bother to keep watching?

For one thing, Venezuela is such a perfect case study that it could serve as a concise example of the whole pat- tern -- which is valuable to any investor who is now, or may in the future be exposed to international markets.

But also, as we noted above, we believe that political instability will be one of the key factors constraining growth in global oil production. The continued slide of Venezuela into chaos is therefore worth examining in terms of its implications for other significant oil producing nations following a similar trajectory. It’s also in- structive for evaluating other resource-heavy economies struggling to escape from the trap -- and deciding what signs need to appear before it’s time to buy.

It All Boils Down to Economics… and Mismanagement

Hugo Chávez, Venezuela’s recently deceased ruler, set out to buy political support by spending the country’s oil wealth. And he used it to buy support not just from the masses of Venezuela’s poor, but from like-minded rulers in neighboring countries such as Cuba and Nicaragua.

Mexico’s state-run oil company, PEMEX, has had a similar history. It’s been the cash cow for the Mexican government, which has used its profits to fund Mexico’s welfare state while starving the company of any funds for maintaining and improving its infrastructure and its production capacity. With production falling, and Mexico facing the end of exports, the Mexican people finally elected a leader who might do something about it: Enrique Peña Nieto. We’re watching closely to see what he can accomplish.

The Venezuelan regime, however, has doubled down on using oil to buy support and stay in power, and the current collapse is the direct result.

Venezuela produces some 2.5 million barrels a day. 800,000 barrels are given away to Venezuelans in the form of subsidized gasoline. 300,000 barrels are given to China to repay government borrowing (the Chinese wisely contracted to get debt payments in oil rather than in Venezuelan currency). 200,000 barrels are given away to regional neighbors. Subtract all that, and Venezuela is left 1.2 million barrels a day to sell at global market prices.

Unlike a resource-rich country like Norway, which has amassed a huge sovereign wealth fund from its oil riches, Venezuela has created a situation where in the midst of plenty, it has to live hand to mouth… and can’t even afford to do that any more.

There just isn’t enough cash flow to (1) pay off Venezuela’s poor, (2) pay international debt that’s denominated in dollars, and (3) invest in crumbling oil infrastructure to stop the inevitable decline in production.

Since the regime is facing protests from the urban middle class -- and the President is publically describing them as “bourgeois parasites” -- it’s a safe bet where the cash will go -- to number (1) above, buying off poor Venezuelans. That means default on external debt is becoming ever more likely (some Venezuelan debt is trading at 63 cents on the dollar). And it means that oil production is falling because of aging equipment and lost intellectual capital… and that will mean, eventually, the end of the whole charade, as the “goose that lays the golden eggs” is slaughtered and the oil wealth finally squandered.

The End Game for the Regime?

Unlike Mexico, the Venezuelan regime is so corrupt and dictatorial that it is going full steam into collapse. That means crushing opposition, outlawing public protests, killing protesters, shutting down dissenting media outlets, and imprisoning political enemies. But since it now has both the army and the national oil company firmly in hand, it may be able to hold on for some time, even if it defaults on its debt.

There are currently many such stories that paint a picture of contracting oil production growth -- whether in Venezuela, Libya, Iraq, Iran, or Nigeria. The details differ; the overall picture is often similar. We look at the picture of global oil supply and demand, and we see two trends. One is rising instability, especially under a U.S. leadership which is explicitly not interested in being “the world’s policeman.” And the other is rising de- mand, as the U.S. and Europe continue to recover and Chinese growth maintains its moderating but still robust trend. The collision of these trends may shape the movement of oil prices in the coming year… with significant effects on the world economy.

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